Speech given by Eiji Hirano, Assistant Governor of the Bank of Japan, at the Harvard Asia Business Conference 2006 "Asia Inc. - Integration & Differentiation"on Feb.11, 2006

February 13, 2006
Bank of Japan

Contents

1. 1.Introduction
2. 2.Economic Development in Asia Inc.
3. 3.Asian Financial Crisis and Central Bank Cooperation
4. 4.Way Forward

1.Introduction

Ladies and gentlemen, it is a great pleasure for me to speak before this distinguished Asia-focused business conference, particularly at my alma mater. I was here at Harvard to study economics in the late seventies. I left Harvard in 1978, 28 years ago, and those 28 years brought dramatic changes in the global economy. Growth did not follow a nice upward curve. In fact, it was bumpy and volatile at times, but we are certainly better off today.

Now the world depends on Asia and Asia depends on the world. This is something unimaginable 28 years ago. What goes on in Asia and what is to come in the years ahead are important for everyone, and I am happy to offer my views at this conference. In my short speech, I will first discuss the economic development in Asia, then speak briefly about central bank cooperation in the region, and conclude with some thoughts on Asian integration in the future. My focus will be on East Asia, which I know best.

2.Economic Development in Asia Inc.

I will begin my discussion with the evolution of the East Asian economy and give my thoughts on the term Asia Inc., which is the main theme for today's conference set by the organizer.

East Asian economies have achieved rapid economic growth over the last fifty years. The consecutive successes in economic development in Asia were lauded as the "East Asian Miracle" in a World Bank publication in 1993. China and India also joined this Asian Miracle a bit later. Japan was a starter and a catalyst of such economic development.

The catalytic role of Japan could be best summarized by the role of Japanese multinational corporations. The notable expansion of Japanese foreign direct investment (FDI) into the region was driven by those corporations, and the investments, in turn, induced trade in manufactured goods. The Plaza Accord in 1985 was a watershed event. The substantial reordering of exchange rates and the appreciation of the Japanese yen against the US dollar encouraged Japanese companies to relocate their assembly lines into East Asian countries. Such FDI stimulated trade, particularly intra-industry trade in manufactured products, and this region's engagement in foreign trade further stimulated FDI activities. The term "FDI-trade nexus" captures the important dynamics of the economic development in the region.

Such corporate activities were supported by public efforts to promote trade and investment under the GATT/WTO multi-lateral framework as well as increasing number of Free Trade Agreements (FTA).

The interdependence of Asian economies is deepening. Momentum for promoting further economic integration is on the rise. This explains why we often hear arguments about a rise of Asian regionalism. It is often discussed in the context of countervailing forces vis-a-vis the US bloc and the European bloc. When discussing Asian regionalism, however, one should look into the nature of Asian integration process with care. To my observation, there are two distinct features in the Asian process.

First, the development of the Asian economy is open to the outside world. The intra-regional trade grows just in parallel with the inter-regional trade. What's more, it is reckoned that the inter-regional financial flows outweigh the intra-regional financial flows. Attention is often focused on the net financial outflows into the United States from Asia, especially in the form of official investment of foreign reserves. However, one should note that there are also huge gross private flows into and out of Asia. The concept of "open regionalism" is a reflection of this reality.

Second, the Asian development is driven by market forces. It is often said that Asia pursues state-driven development strategies, holding down exchange rates to their advantage. In fact, there are prevalent hypotheses which insist the government interventions to promote industrial development played a significant role for the high growth in the region. However, we must not forget that China and India were transformed into economic powerhouses only after their governments decided to loosen their grips on the economy. The recent acceleration of the Asian economy has clearly been market-driven, and more the fruit of private entrepreneurship than of the guidance of the state.

The term Asia Inc., a metaphor of Asia functioning as one big company, has been put up as the main theme for today's conference. But considering the two reasons I have just mentioned, Asia Inc. is largely a myth. Asia is a free and dynamic economy, rather than one exclusive big company.

3.Asian Financial Crisis and Central Bank Cooperation

Having said that, let me move on to the financial aspect of Asian development.

The deepening of East Asian regional economic interdependence contrasts with the relatively underdeveloped financial markets. Weak financial intermediary function within the region has meant that ample savings in Asia seem to be less utilized than its potential. In financing investment, Asia had to depend on short-term, dollar-denominated foreign funds, which created mismatches both in maturity and currency. Such weakness was brought to the surface in 1997-98 in what we recall as the "Asian financial crisis." Financial turmoil was especially acute in Thailand, South Korea, Indonesia, the Philippines, and Hong Kong.

The Asian financial crisis was a wake-up call for the East Asian economies. Asia was made aware of the imminent need to develop a robust financial system in order to withstand future shocks and sustain stable economic growth. The necessary financial reforms were broad-based. Strengthening the banking system was a high priority, as Asia's financial intermediation is predominantly bank-based. Also high on the agenda was the development of bond markets in pursuit of deeper, more efficient, and more resilient financial markets. Japan was anything but the exception.

Fixing an impaired financial system and initiating financial market reform are largely in the domain of central banks. Thus, central banks of the East Asian economies are deeply involved in the process of financial reform. What is more, central banks' engagement in pursuing greater financial stability naturally prompts cooperative efforts in tackling the financial agenda, which Asia shares in common. Let me describe a couple examples of such cooperation.

You may have heard of the Chiang Mai Initiative (CMI). This is a joint initiative by the governments and central banks of ASEAN10 + 3 economies. The idea is to secure financial stability in the region by creating a network of bilateral swap arrangements to serve as a cooperative liquidity supporting mechanism in times of stress. Up to date, 16 swap agreements have been concluded with the aggregate amount of approximately 60 billion dollars. This facility is designed to supplement the existing global financial facility provided by the IMF.

Probably less known but another important central bank initiative concerns the activities of EMEAP, i.e. the Executives' Meeting of East Asia-Pacific central banks. EMEAP is the gathering of the 11 central banks and monetary authorities of Australia, China, Hong Kong, Indonesia, Japan, South Korea, Malaysia, New Zealand, the Philippines, Singapore, and Thailand. EMEAP was founded in 1991 in response to a Bank of Japan proposal. It has succeeded in promoting central bank cooperation in this part of the world.

One tangible fruit of EMEAP activities is the launch of what is called the Asian Bond Fund. The Asian Bond Fund is the EMEAP central banks' joint investment fund which invests in sovereign and quasi-sovereign bonds issued by EMEAP economies other than Australia, New Zealand, and Japan. ABF1, launched in 2003, invests in the dollar-denominated bonds and is open only to EMEAP central banks. ABF2, launched in 2005, invests in the local-currency-denominated bonds and is open also to private investors with the aim of providing investors with low-cost and index-driven investment vehicles. EMEAP central banks promoted this project in close cooperation with market participants and other monetary authorities.

The purposes of this unique central bank project are to increase investors' awareness about Asian credit, to identify supply-side impediments that prevent cross-border investment in the region, and to help mitigate them from the viewpoints of investors. We observe that similar kinds of index-driven private bond funds are rapidly emerging. In this regard, the ABF project is actually playing a catalytic function.

Frankly speaking, there is a long way to go before we see robust and integrated financial markets in the region. Nevertheless, the episodes I just mentioned are encouraging signs of increased momentum.

4.Way Forward

Asia is becoming increasingly integrated. This is largely a spontaneous process, which makes a clear contrast with the European integration process, where political will played a leading part. Can Asia continue to deepen integration further just by following the path set by precedents? I have three observations on which adjustments may be necessary.

First of all, it is necessary for Asia to have an orderly process for the formation of political will. Political tension between Japan and China is of a particular concern. We need a sure mechanism to appease tensions by establishing general understanding in the common benefits of deeper integration. In this context, the first East Asia Summit last December in Kuala Lumpur, Malaysia was a good step forward to overcome political sensitivities in the region. Politics must be a part of the solution, rather than a source of problem.

Second, Asia needs to unleash more market forces. Efforts to develop deep and efficient financial markets must be pursued more forcefully. Corporate governance must be improved. We must see less state intervention in corporate decisions. In particular, China needs to step up efforts in its transformation into a market-based economy. Central bankers tend to put disproportionate weight on the state of currency to assess credibility of the economy. In this context, realizing international convertibility of the Chinese RMB on the back of a stable and well-balanced Chinese economy is a prerequisite for Asia to move on to a higher stage of integration.

Third, credible macro-economic policy to maintain sustainable economic growth with price stability must be pursued by each Asian economy. Integration amplifies economic and financial shocks in the region in either direction, positive or negative. This is the reason why credible macro-policy in each economy is warranted.

On our part, the Bank of Japan must conduct its monetary policy carefully, as Japan emerges from a prolonged stagnation. Achieving sustainable growth with price stability is the greatest contribution we can make to Asia as well as the world at large.

In concluding, I would like to briefly touch upon the Bank of Japan's renewed commitment to promoting central bank cooperation in Asia. In November last year, the Bank introduced the Center for Monetary Cooperation in Asia, or CeMCoA. CeMCoA has three main objectives: first, supporting EMEAP activities; second, strengthening our technical assistance capacity to central banks in the region and beyond; and last, enhancing research activities in Asian issues in cooperation with outside professionals, including those at Harvard.

With this last bit of PR, I will end my presentation. Thank you for your attention.